Cash Balance Plans Could Overtake 401(k)s

The Texas-based investment management firm recently released research that cites figures from the U.S. Department of Labor, which illustrate the rise in popularity of cash balance plans. In 2001, there were less than 1,500 such plans. By 2010, there were more than 7,500—an average growth rate of around 20%.

Sage’s findings also show many mid-size and small businesses are seeing the advantages of such plans (e.g., flexibility, transparency, employee satisfaction).

“Fedex, Coca-Cola and Dow Chemical have or have had cash balance plans,” Alex Pekker, co-author of the research and a vice president with Sage, told PLANSPONSOR. “With the larger firms it can be tied in with the presence of large unions. With our research, we have seen more mid-size companies (such as high-tech firms and law firms) and smaller companies (such as medical offices) express interest in having a cash balance plan.”

One of the big advantages is that they let more money be contributed, Meghan Elwell, co-author of the research and a vice president with Sage, told PLANSPONSOR. “No other retirement vehicle does such a good job at shielding retirement savings via tax deferment, especially in combination with a 401(k) plan. After 2008, many people, Boomers especially, were left with a much smaller nest egg that they expected. Cash balance plans allow them to quickly ramp up on saving.”

What Is a Cash Balance Plan?

A cash balance plan is a variation of a defined benefit retirement plan. Employers make a contribution to the plan on the employees’ behalf. Since cash balance plans have some characteristics of a defined contribution plan (e.g, creating participant accounts), they are also known as hybrid plans. Employers contribute to these accounts based on an interest crediting rate (ICR) and a percentage of the employee’s pay. This, says Sage’s research, produces a plan that is easy to understand.

The research advocates a “common sense methodology,” whereby cash balance liability matching is the sum of the participants’ account balances. The methodology also calls for illustrating investment scenarios for plans with different ICRs such as fixed rates, bond yields and index returns.

Challenges of Cash Balance Plans

There are, however, hurdles that a company still needs to clear before adopting a cash balance plan. When it comes to managing the assets of such a plan, there are challenges.

“It is not like a traditional defined benefits plan or a total return plan,” Pekker said. “First is the ICR and designing a targeting mix that achieves the plan’s goals. There’s also liquidity risk, which ties into lump sum payments, to be considered. Also, you never really know when people will terminate their employment, or retire and take a lump sum payment.”

“You also have to consider the risk preferences of the plan sponsor, the size and structure of the company,” Elwell added. “It’s really not one size fits all.”

Investing Cash Balance Assets

There’s not a single best investing strategy for cash balance plans, contended Pekker. “It can depend on whether the plan is new or converted. If it was converted from a defined benefit plan, there may be obligations from that plan that need to be fulfilled. The key is flexibility.”

Elwell added, “What we have seen is that some companies will go with as much as 100% fixed income investments, while others may invest 20% to 30% outside of fixed income. There are volatility issues to consider, seeing as it’s a pretty risk-averse environment out there.”

Plan sponsors have several ways of determining their risk tolerance, according to Pekker. “Different market scenarios have to be considered and the company needs to see how they will respod to each one of them.”

“The company has to determine if they can handle the environment of an averse market,” adds Elwell. “Is too much pain going to be felt and will the plan require them to make additional contributions? These are questions that have to be asked.”

The research concluded that in a relatively short period of time, cash balance plans have gone from being a novel part of the retirement plan system to being an increasingly common form of retirement plan. Given the current macroeconomic environment, demographics and tax policy, this trend is likely to continue into the next decade.